View From The Top

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

View from the very top: equities remain our preferred asset class entering 2014, but regional allocation and stock-picking will be crucial, especially with falling correlations. Don’t rule out the risk of a market correction given the absence of major market drawdowns in the last two years and potentially high levels of complacency. All regions will need to manage transition and we expect there to be an increasing focus on fundamentals.

Asset Allocation:

Equities: We favour high-conviction global managers with a strong approach towards bottom-up stock-picking and an emphasis on high-quality businesses with sustainable franchises and corresponding free cashflow generation. From a regional perspective, our preference is for Japan and Europe over the United States. Emerging markets are looking potentially attractive for the longer-term investor.
Credit: We believe yields in general are not yet at compelling enough levels to be appealing and therefore only have selective exposure to this asset class, typically via mangers with flexible mandates. Our general inclination would be for corporate credit over government debt. If the US 10-year yield reaches 3.5-4.0% (3.0% at present), then credit may look more interesting.
Alternative Asset Managers: We see a strong case for event-driven managers in particular. 2013 was the slowest year for global M&A since 2002 and with improving global economic prospects, corporates may begin to think more about investment than just capital return. Expect the return of cross-border M&A.

Most investors appear to be entering 2014 in high spirits, particularly if their allocations have been oriented towards equities. After all, global markets experienced in 2013 their best year in performance terms since 1997. Confidence levels, therefore, are buoyant and a backdrop of still broadly accommodative monetary policy and accelerating economic growth is undoubtedly encouraging. While we would not disagree with a preference for equities strategy, several words of caution are also merited.

First, in order for equities to move higher, policymakers clearly need to manage transition successfully. If this is done effectively, then corporates stand an increased chance of being able to convert accelerating economic momentum into corporate earnings, helping justify valuation levels. By managing transition, this is an issue for all regions globally: practically this means moving from policy-induced to private sector growth in the US; from nascent recovery to tangible top-line improvement and margin expansion in Europe; from anaemic prospects to the presence of (moderate) inflation in Japan; and, from export-dependent to more sustainable, domestically oriented growth models in emerging markets.

Even if equities do manage these transitions successfully, investors should be mindful of the fact that current levels of assuredness and hence also expectations appear almost abnormally high, prompting the risk of a possible correction at some stage in the coming months. It is worth remembering that the MSCI World has endured only one monthly drawdown of over 5% in the last two years while the VIX measure of volatility averaged just 14 during the past year, compared with 18 and 23 for the two years prior.

At the very least these observations suggest that the crucial debate should not currently be about equities relative to other asset classes, but where to position within equities. We would expect 2014 to be another year that favours active over passive strategies. Indeed, research from Goldman Sachs shows that correlations between members of the main indices in both the US and Europe are currently three times lower than where they were during the credit crisis. In terms of equity positioning, we believe three factors matter: central bank balance sheet expansion, valuation and earnings prospects. Taken together, the strongest case can currently be made for Japan, followed by Europe.

Notwithstanding the Fed’s commencement of tapering later this month, Credit Suisse calculates that central banks will, in aggregate, grow their balance sheets by close to 20% in 2014. We expect the fastest pace of enlargement in Japan with a possible second round of easing announced before the spring, while Mario Draghi at the ECB remains highly pragmatic and may well experiment with other unconventional monetary tools.

A regional asset allocation strategy based around central bank policy has been a successful approach for investors to adopt in recent years, and the logic is persuasive, particularly if monetary accommodation does help drive (or at least support) growth. It is notable that Morgan Stanley’s strategists are forecasting gains of 18% in earnings for corporate Japan over the next year, treble the rate anticipated for the US (6%) and also markedly ahead of their expectations for the Eurozone (10%) and emerging markets (6%). Earnings upgrades inevitably also provide support for valuation levels, a factor that allows us to make the case for Japan despite the Nikkei’s greater than 50% rise in 2013. On a cyclically adjusted (CAPE) earnings basis, Japan remains one of the cheapest markets in the world (mainly after the Eurozone periphery). By contrast, America’s 30% valuation premium relative to history is stark. Europe looks cheap both against the US and its recent past.

As far as managing transition is concerned, taking the US first, a delicate balancing act is required. The Federal Reserve has undoubtedly done a good job in delivering a credible message regarding its phased reduction of quantitative easing, but pressure remains on incoming Chair Janet Yellen to navigate the uncharted territory of balance sheet shrinkage and full exit. To the Fed’s credit, there has been a notable stress on flexibility and the fact that rates can theoretically remain low for a long period, especially in the absence of inflation.

The biggest danger, however, is perhaps not that the Fed fails to communicate accurately in the near-term, but simply that the economy grows too quickly potentially requiring an upward move in rates earlier than anticipated. Annualised GDP growth in the US was revised up to 4.1% for the third quarter, industrial new orders are currently running at their highest in almost three years and housing starts surpassed 1m last month for the first time since early 2008. Moreover, there will be notably less fiscal drag in 2014 than 2013. It will be important to watch these factors over the coming year. As crucially, US corporates especially will need to demonstrate that they can translate these better economic prospects into tangible earnings growth, thereby justifying current multiples. According to JP Morgan though, US corporate margins are still over 100 basis points below their 2006 peak, implying scope for improvement, particularly given low inflation levels.

For Europe, 2014 will also see an increasing emphasis being placed on fundamentals. Crisis may well have been averted and Mario Draghi has helped improve the ECB’s credibility, but the region has not seen economic growth (or its corporates annualised earnings expansion) since 2010. This could change over the year, particularly given six consecutive months of positive industrial production readings and unemployment now falling for the first time since early 2011, albeit from a high base.

However encouraging these headline improvements may be, they continue to mask the disparities that remain between the divergent prospects for Germany and northern Europe relative to the periphery (and, arguably, France). It is against this background that in order for the Eurozone’s recovery to be structural, reform needs to be undertaken. Low inflation (of just 0.9%) and still stagnant private sector credit creation make a strong case for imminent action and political consensus across the region appears higher now than at almost any stage since 2008. The ECB has a number of tools at its disposal and a continent-wide funding-for-lending scheme (similar to that adopted by the Bank of England) or a second round of long-term refinancing options would both be logical. If the Euro continues to appreciate, negative deposit rates may even be a possibility. Developments may also be made towards continent-wide banking union during the year.

Major progress has been made in Japan over the past year, but much more will likely be made in the coming 12 months. It should not be forgotten that Prime Minister Abe has only been in power since December 2012 and Central Bank Governor Kuroda since April 2013. Moreover, reform was never going to be easy or immediate, and some setbacks inevitable. Doubters should remember that business confidence (measured by the Tankan survey) stands at its highest in six years, and this is particularly crucial given the impending season of wage negotiations. Several major companies including Hitachi, Honda, Nomura and Toyota have all already signalled planned increases of 5-8% and if such packages become widely implemented, then Japan stands a serious chance of generating tangible inflation. Average wages in the country have not increased for fourteen years and so the psychological impact of such a development should not be under-estimated. Furthermore, a virtuous circle effect could be created should we see further monetary easing and/or structural reform.

In contrast to Japan, a number of emerging economies appear to have entered a vicious circle driven by falling growth, rising interest rates and an exodus of foreign capital. US tapering and a higher Dollar may also compound these effects. However, after three years of emerging market underperformance relative to developed markets, there is an increasingly compelling valuation case for the former, particularly given both current valuation disparities and structural growth arguments. There is always a danger in generalising about emerging markets, but it would seem clear that those with more mature and credible business models based less around exports and more around the domestic consumer could prosper. Against this background, nations such as Brazil, India, Indonesia and Turkey (all of which also face electoral uncertainty in 2014) look less well placed than the countries of Eastern Europe as well as Korea and Mexico. Stock-picking will again be crucial in this region, as it will likely be globally for the months ahead.

Alexander Gunz, Fund Manager, Heptagon Capital